Even as the European sovereign debt crisis makes the headlines, economists and fund managers have begun to worry about the possibility of a bigger catastrophe: a slowdown or even a recession in China. This year China is expected to provide a third of global economic growth. If instead of acting as the global economy's growth engine, it becomes a laggard, the consequence would be, as one fund manager calls it, "the mother of all black swan events".
Among those who argue that China's growth will soon slow down to around 2-3 per cent is Harvard University Professor Kenneth Rogoff. The essence of his argument: China's GDP has been growing at or near double-digit rates for 10 years, hence a slowdown is overdue as no economy can indefinitely beat the business cycle. Hedge fund manager Jim Chanos of Kynikos Associates (famous for having shorted Enron's stock) has also warned that China is on a treadmill to hell because it is hooked to property development to drive growth.
Why the dragon will slow down...
The predictions of a slowdown hinge on the following arguments:
Western customers de-leveraging. The fundamental argument goes as follows: China exports goods to the developed world. US and European customers are now de-leveraging, so their consumption rate will be lower in future. How then can China keep growing at the same rate as in the past?
Excess capacity building. Despite its scorching growth rate of the last 10 years, more capacity continues to be built under the assumption that this high growth rate will continue. Overcapacity within China, charge critics, has been taken to the extreme. China's excess capacity in cement exceeds the total consumption of US, Japan and India combined; its idle capacity in steel exceeds Japan and South Korea's total production. Real estate bubble. China has developed too much real estate, say critics. One oft-cited example of wasteful construction is the South China Mall, the world's second-largest mall with 7.1 million square feet capacity. Though it opened in 2005, 99 per cent of space within it remains unoccupied. Similarly, Ordos, a city for one million residents built in inner Mongolia, remains a ghost town. Moreover, the pace of construction shows no sign of letting up: in 2009 total floor space construction was up 100 per cent. According to critics, a lot of the stimulus money meant for infrastructure projects leaked into the real estate market, fuelling a bubble, especially in the bigger cities.
Bad loans likely to mount. As part of the stimulus, bank lending for infrastructure projects was channelled mostly to quasi-government agencies called local investment companies. In many cases, these loans have been guaranteed by local governments. The total bank loans plus debt issuances of these companies amount to RMB 6 trillion (equals 20 per cent of China's GDP). It is feared that local companies may not be able to repay their loans since the projects being funded are uneconomical. If these loans are factored in, say critics, the government's finances appear to be in poor shape.
Chinese consumers can't pick up the slack. Finally, critics argue that if Western consumers buy less from China in future, the only way its growth can sustain is if domestic consumers pick up the slack. That is doubtful. The transformation from an export-centric economy to a consumption-centric economy will take years to happen, they say. Besides, consumption comprises two-third of the GDP of US and Europe, which cumulatively are much larger in size than the Chinese economy; consumption comprises only one-third of a much smaller Chinese economy.
According to critics, thinking about China gets coloured by the belief that since its economy has grown rapidly over the last 30 years, it will continue to do so in future as well. This is an erroneous belief, they say. Further, they add that the world only focuses on China's financial strength, such as its $2.3 billion foreign reserves. It does not look at it liabilities, such as the government-backed loans made to local companies, which could produce liabilities running into trillions of dollars.
...And why it won't
Those who believe that the Chinese economy will continue to grow robustly say that the fears of a debt-fuelled bubble bursting and causing China's growth to plummet are exaggerated. Among them is Nicholas R. Lardy of the Peterson Institute for International Economics.
Authorities combating property bubble. Lardy says that the authorities initiated steps as early as mid 2009 to slow down lending to the property sector. These included reinstating sectoral limits on bank lending to real estate, raising banks' reserve requirements and tightening their capital adequacy norms, reinstating the 40 per cent down payment requirement (reduced to 20 per cent during the slowdown) for purchase of residential property, and raising the holding period required for availing tax exemption on capital gains from property sale from two years to five.
Further, Lardy argues that even if there is a price correction in Chinese real estate, it will not have the same disastrous impact as in the US. Chinese buyers take on much less debt to buy houses. In China prices would have to correct 20 per cent or more before owner's equity becomes negative, leading to more margin money requirement or foreclosure. In the US even a slight decline pushed owner equity into negative since buyers made zero down payment.
Excess capacity is no big deal. The supporters also argue that there is difference between 20 per cent excess capacity in an economy growing at 3-4 per cent versus the same in an economy growing at 10 per cent. In the former, it will take around seven years to absorb the excess capacity; in the latter, just two. So the financial cost of carrying this excess capacity is not ruinous.
On hidden government debt. The supporters accept that the financial returns from the infrastructure projects being implemented by local investment companies may be low because user charges tend to be low in China. But China, they say, is in the midst of a large rural to urban migration. So the long-term real economic benefits of these infrastructure projects will be high.
Only time will tell which set of arguments prevails. However, while a slowdown in China may be disastrous for commodity exporters such as Australia, Russia, Brazil and the Middle East, it may not be so for a commodity importer like India. Softer price of oil will ease the government's fiscal burden. Softer metal prices will provide relief, especially to manufacturing firms that use them as inputs. Companies involved in capital expansion, such as the Power sector which is buying new equipment, or the telecom sector which is expanding its network, will also benefit from lower commodity prices of steel, copper, etc. Shipping and mining will, however, be adversely affected. Finally, if you sense that the Cassandras are turning out to be right, exit investments in industrial and construction related commodities since these will definitely underperform.
This article was originally published on July 06, 2010.
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